Is Indonesia next in line as hot bed for investment?

John Riady, The Jakarta Post

Will 2007 see Indonesia's resurgence as a global hot bed for investment? A New York fund manager, asked why his company has not returned to Indonesia, said: "Well, Indonesia's small potatoes these days. Besides, there's too much risk and no upside." Such remarks are too often heard and leave a negative stereotype of Indonesia in the eyes of foreign investors.

In the early 1990s, Indonesia was touted as the next Asian tiger. Investors from around the world flocked to Jakarta struggling to get a slice of the action. Today, many people are anxiously holding their breath, asking when this long-awaited second coming of investment will arrive. The second coming is not imminent-at least not in 2007.

Many people believe corruption to be the main culprit behind Indonesia's weak investment and sub-optimal economic growth. But this is far from the truth. Anybody that has done business in China would concur that China is tantamount to corruption, yet they have been flirting with a double-digit growth rate. Corruption is not the problem. The problem with Indonesia is its lack of decisive government leadership, which unfortunately shows little sign of improvement.

Second of all, massive investment will not come until Indonesia's sovereign rating reaches a minimum of "investment grade" level. Although Indonesia is moving in the right direction, it cannot happen overnight. It is unlikely to happen even in the year to come.

Ultimately, the litmus test is whether Indonesia can compete. What has our government done to allow Indonesia to compete with other investment destinations? Indonesia's incentives are unattractive and its infrastructure is dismal. Indonesia does not have to be competitive in everything, but as it is, it is competitive in nothing.

On a slightly more positive note, it has been a year since the fuel subsidy cuts, and a combination of lower inflation and falling interest rates have helped Indonesian consumers to rebound. But government spending, which has helped push growth in the second quarter, seems to be slowing down, and growth in exports have been more in value rather than volume.

Investment too, has been sluggish. Foreign direct investment from January to October of 2006 has dropped 48 percent compared to the same period in 2005. A more dynamic economy must be driven by investment.

In response to the three challenges to attracting investment as stated above, here are some recommendations for the Indonesian government: First and foremost, the Indonesian government must show decisive leadership. Only if we can assume that our government actually has the ability to exercise decisiveness in policy-making and effective implementation -- a big if -- can discussion about the particular policies then be useful.

Granting the fact that our president comes from a party that controls only 11 percent of the House of Representatives, Susilo Bambang Yudhoyono must stop trying to please everyone. Our president's lack of decision making is attracting widespread ridicule. There are not very many areas where I believe Yudhoyono should learn from President George Bush. Learning to be unpopular is one of them.

More concretely, there are three areas that our government should focus on to increase Indonesia's competitiveness: in implementing the correct incentives, investing in infrastructure, and adjusting the "price" of doing business in Indonesia to an appropriate level. Allow me to elaborate.

Incentives can best be achieved through the use of taxes. Taxes serve four functions: To raise revenue, redistribute wealth, punish unwanted actions, and encourage favorable behavior. It is a pity that Indonesia currently only uses taxes for the first purpose, and arguably the second. The development of China's special economic zones was predicated on tax incentives. The same is true for Singapore's ability to attract investment. While Singapore, a country of four million people, attracted US$20 billion of foreign direct investment in 2005, Indonesia only attracted a mere $6 billion. Indonesia should follow suit.

No country is perfect. Having that said, to attract investment, a country must compensate its weaknesses. Workers in China are uneducated, yet factories choose to relocate there because it is cheap (although becoming less so) and relatively productive. Indonesia's workforce, like China's, is also generally uneducated. But in addition, due to labor regulations that dampen labor mobility and reward the wrong behavior, Indonesia's workforce is neither cheap nor productive. Indonesia must reform its labor and investment laws.

Infrastructure is also vital to attracting investment. Dubai and Sharjah, both neighboring emirates of the UAE, are real world examples. Both states are endowed with billions of petro-dollars; and both are also located in the middle of the dessert. The difference: While Dubai has received more investment than the combined amount of money controlled by the top four investment banks on Wall Street, its neighboring emirate has not changed much since the time of the Prophet Muhammad.

The variable that best explains the difference is the amount of hard infrastructure, such as roads and proper sewage, and soft infrastructure, namely an educated workforce, which Dubai has managed to accumulate. There are many reasons that make the Middle East a poor comparison to Indonesia. However, the fact remains that if a country makes the necessary investment in infrastructure, people will invest.

Indonesia needs around $70 billion of infrastructure investment over the next five years. Poor infrastructure is hampering Indonesia's ability to not only accelerate economic growth, but also in being able to deliver basic public services. Indonesia is already experiencing power shortages and 70 million people still have no access to electricity; this will be exacerbated as demand grows by 7-9 percent annually.

The same picture emerges with regard to sewage networks. Half of all district roads have been classified as "poor or in bad condition". There are around 649 km of toll roads, but the country needs a minimum of 2,000 km. Almost 75 percent of shipments out of Indonesia are re-loaded onto larger ships at Singaporean or Malaysian ports because of inadequate port capacity at home causing exporters to lose $700 million annually in foreign exchange. Furthermore, devastation caused by natural disasters in Central and West Java has increased the need for infrastructure.

While inducing investors through tax incentives and the development of infrastructure is good in theory, it may prove to be too difficult for Indonesia.

A more feasible alternative would be to adjust the value of doing business in Indonesia to a competitive level. This could be done, for example, by doing what China has done: adjusting the rupiah to, say, Rp10,000 to US$1. By doing this, goods made in Indonesia would cost less to produce, and hence making them more competitive. This should in turn boost exports and attract investment. This alternative no doubt has its pitfalls but our government should at least give it a serious consideration as it may be the wise course of action given the existing constraints.

If incentives, infrastructure, and value adjustments as explained above are relatively short term policy areas, two longer term measures that should also be enacted is in regards to Indonesia's country rating, and education.

First, positive country ratings is a prerequisite for large scale investment. Most investors manage funds that belong to other people. These managers take risks on every investment they make and must to some extent be able to justify the risk they incur. A more favorable rating will allow investors to justify investing in our country, and also give them a certain level of comfort. Also, bad ratings translate to a higher cost of capital and thus a loss in companies' competitiveness.

Before moving on to the fourth and final point, it is important to take a step back and remind ourselves why it is that a country desires investment, or more particularly, FDI. Economists tell us that FDI is desirable, amongst other reasons, because it facilitates the transfer of technology, and stimulates domestic investment. Such things are in turn favorable because they contribute to economic growth. Economic growth, then, is desirable because it will hopefully help eradicate poverty and decrease unemployment. This will in turn improve living standards.

Consequently, given the ultimate end of FDI in improving the living standards of Indonesians, this fourth point is perhaps the most compelling: Indonesia must invest in education to empower its people and accelerate growth.

Education's impact is twofold.

First, it has a direct positive impact on living standards, which we have said to be the goal of FDI. Second, more education means a better educated and more productive labor force-the kind of soft infrastructure Dubai has. Given that wages do not increase proportionally to equalize the relative price of labor in relation to productivity, this should attract more investment.

Economic measurements, such as GDP per capita or investment per head, are mere numbers that are supposed to reflect the well being of a country's population. While the achievement of more positive figures could be a result of a real improvement in the well being of a country, this is not necessarily so. For example, GDP per head could be increasing but if inequality also increases, the increase in GDP will be accrued by those who least need it.

Investing in education is probably the surest way to guarantee that a real and qualitative improvement in lives is attained.

Indonesia's future is promising and the second wave will come. Indonesia has gone a long way in rebuilding itself since the East Asian financial crisis, and it has also coped pretty decently with the constraints that this so-called democracy has imposed.

While it is proper and salutary that governments should in general leave economics alone, it is however, right that from time to time they offer leadership and encouragement. Currently, carrying out the necessary policies to set the stage for investment would be prudent.

Unfortunately, prospects for improvement are mixed given that Jakarta may find it hard to make politically difficult decisions as the 2009 presidential election draws closer.

However, if successful, perhaps by this time next year, Indonesia will be next in line as the world's premier destination for foreign investment.

The writer is a Government and Economics graduate of Georgetown University. He can be reached at jr284@georgetown.edu.